Janet Yellen: A Tiny But Powerful Woman Who Has Wall Street Worried

Janet Yellen sworn in as Federal Reserve board governor, October 4, 2010.REUTERS/Ho New

Supervision at the San Francisco Fed wasn’t without its faults.

The 12th district saw 13 of its banks fail from the day that Lehman Brothers declared bankruptcy in 2008. In almost every case, the banks had huge concentrations of construction and commercial real estate loans on their books, loans that defaulted disproportionately when the real estate markets in the Western states collapsed.

The Fed’s inspector general issued reports on most of those failures failure. When Merced, Calif.-based County Bank collapsed, costing the FDIC $135.8 million, the inspector general said the San Francisco Fed supervisors could have done more.

“We believe that the magnitude and significance of County's asset quality deterioration and credit administration deficiencies that emerged in the summer of 2007, coupled with management's disagreement with regulators, warranted a more direct and forceful supervisory response by FRB San Francisco,” the report said. The inspector general went on to say that because of the collapse of real estate values, the bank might have failed anyway.

Overall the San Francisco Fed Bank had the third-highest number of bank failures during the crisis of all the Fed district banks, after Chicago and Atlanta.

And Wells Fargo, the biggest bank under the supervision of the San Francisco Fed, borrowed $25 billion under the 2008 bank bailout known as the Troubled Asset Relief Program.

“Looking back, I believe the regulatory community was lulled into complacency by a combination of a Panglossian worldview and benign experience,” Yellen said in a speech in Denver in 2010.

When Obama asked Yellen to come back to Washington to serve as the Fed’s vice chair in 2010, she was fresh from the trenches of dealing with the real estate crash and collapsing banks. She saw for herself where bank regulation and supervision failed.

Systemic risk

She says the crisis made it clear that regulators weren’t simply too lenient, they also weren’t looking at the system in the right way.

At the Fed board in Washington, Yellen leads the group that does research on systemic risk in the overall financial system. She said she sees the current strategy — strengthening banks and ensuring there’s a way to deal with them if they collapse — as a “belt and suspenders” approach.

“We don’t want these entities to fail. We want to make them much more robust and less likely to come under pressure,” she said. ”Then if something did happen, we would have a way to deal with it that we were not able to do during the financial crisis.”

And while the vast majority of her public speeches still focus on the U.S. and global economies, she has occasionally addressed the financial system and regulation.

She said in the interview that she doesn’t favor breaking up too-big-to-fail banks, but would demand they hold more capital than international regulators now propose. The so-called Basel committee of global regulators has suggested a capital ratio 2.5 percentage points higher for financial institutions deemed systemically important.

And she supports the Fed’s proposal to require foreign banks that operate in the U.S. to organize U.S.-based holding companies that meet U.S. capital requirements, a plan that foreign banks and European Union officials oppose.

In a letter to Bernanke, the EU Commissioner for Internal Markets Michel Barnier called the proposal a “radical departure” from previous rules that could “result in a competitive disadvantage” for foreign banks.

In a January speech, Yellen got on the wrong side of derivatives traders.

Derivatives are financial contracts that investors use to bet that the price of a certain equity, commodity or other instrument will rise or fall as of a future date. Traditionally derivatives are used to hedge against price swings in commodities such as oil, corn or interest rates.

Before the financial crisis, however, investors created derivatives to bet on almost anything, from changes in the weather to the likelihood that Lehman Brothers would default on its debt. The face value of derivatives reached $596 trillion in 2007, about four times the value of all the financial assets in the world. Derivatives of mortgages played a role in the financial crises, and credit default swaps —a type of derivative —caused the collapse of insurance giant American International Group.

Post-crisis rules now require standard derivatives be traded through an exchange, where investors will have to provide capital to guard against losses during the term of the contract. They can get around the rules, however, by creating custom contracts.

Yellen says she wants to require companies that trade derivatives over the counter to post initial margin to ensure they can meet future losses, as well as posting interim margin if the value of the trade falls. Making the contracts more expensive might also encourage traders to go back to the exchange.

“Even in light of the significant costs of initial margin, it seems clear that some requirements are needed,” she said.

“We still harbor grave concerns about the initial margin requirements,” four trade associations wrote in a letter to global bank regulators. “The IM requirements do not appear to meet any objective cost-benefit analysis.”

Industry objections might even boost Yellen’s chance of being nominated.

“It would be hard to envision president Obama naming anyone as fed chair who wouldn’t be tough on the banks,” Seiberg of Guggenheim Partners said in an interview. “All the political pressure in the world remains in favor of making sure the biggest banks have lots of capital and have changed their business practices so we don’t get another crisis. Yellen fits the mold.”

The Center for Public Integrity is a non-profit, independent investigative news outlet. For more of its stories on this topic go to publicintegrity.org.